Aeropostale’s Margin Recovery Relies on Cost Cutting & Easing Inflation Pressures

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Trefis
ARO: Aeropostale logo
ARO
Aeropostale
Aeropostale

Source : Google Finance

Aeropostale (NYSE:ARO) stock has taken a pounding the last few months and investors will get a much anticipated update later this week when Aeropostale reports earnings. The stock started dropping after its dismal outlook following its Q1 results in May 5. This was further accelerated by a massive drop of 10% in the company’s gross margins as reported in the quarterly results. Then just a few weeks back, Aeropostale announced its Q2 sales outlook calling for declines in net sales and double digit declines in same store sales. As a result, Aeropostale has reached a new 52-week low with the stock price falling by 20% to reach below $12 currently.

We have revised our $26 price estimate for Aeropostale’s stock based on disappointing Q2 sales, which still implies a premium of about 100% to the market price. This view is predicated on the assumption that profit margins will recover in the medium term. Below we look at some of the factors that contributed to the decline and what the company may do to fix this.

Why is the Market Throwing in the Towel?

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We believe the following reasons contributed to Aeropostale ’s slide in recent months:

1) Aeropostale is losing its edge in promotional business

Historically, ARO’s major selling point has been its business as a cheap option for teenagers to find fashionable clothes. The competition in teen apparel industry is exceedingly fierce with Aeropostale competing with brands like Abercombie & Fitch (NYSE:ANF), American Eagle Outfitters (NYSE:AEO), Buckle (NYSE:BKE), Body Central (NYSE:BODY) and others. With competitors such as Abercombie & Fitch embracing promotional businesses and offering discounts, Aeropostale’s distinction as the biggest promotional teen retailer is fast diminishing. This has resulted in sales declines for Aeropostale and further forced the company to increase its promotional activities resulting in higher costs and lower margins.

2) High production costs is taking its toll on Aeropostale

Rising cotton prices have been one of the most significant reasons for the downward slide in the stocks of many apparel companies in the past year. The effect is more pronounced on value oriented retailers since these companies are more reluctant to pass on the cost increases to customers in fear of losing business. As a result, ARO’s margins have taken a hit. The shrinking margins topped with falling revenues have caused Aeropostale’s stock to plummet.

How We Justify Our Sanguine View

Although we believe that the above mentioned issues will cause Aeropostale’s stock price to remain depressed for the foreseeable future, the market seems to have taken a short-term view of Aeropostale’s problems. We are less bearish on Aeropostale than the market longer term as we believe the company will be able to resolve some of these headwinds in the coming quarters.

1) Rising Commodity Prices

Cotton was at $0.84 per pound in July 2010 and peaked at $2.30 per pound in March 2011. The major factor behind the cotton price increase was the drought in the Hubei province of China, a major cotton producing area followed by government restrictions on exporting cotton out of India to safeguard domestic supplies and a devastating flood in Pakistan.

Cotton Prices

Cotton Prices Source : Index Muni

As the normal supply of the crop from China resumes, cotton prices have started to show signs of returning to normalcy. We expect the trend to continue throughout 2011 which will ease up the pressure on margins.

However the effect will be offset by downward pressure from increasing promotional costs due to competition. We expect this to be a short term phenomenon as Aeropostale increases its cost cutting measures like reducing inventories and slowing the number of new store openings. Hence we believe the margin compression that the market expects for 2011 and 2012 will be transitory and should recover. On a longer term horizon, falling cotton prices and Aeropostale’s focus on cost controls will help the improve margins over time. Strong sales as we head into back to school shopping will certainly help.

Valuation Differences

We believe that most investors are valuing the company by applying an earnings or EBITDA multiple on currently depressed earnings. This leads to lower valuation than ours as we value ARO on its future cash flows and currently expect margins to recover. As such, the currently depressed earnings don’t impact its overall valuation as much as using a forward earnings multiple will.

See our complete analysis for Aeropostale stock here